Solid returns from infrastructure funds come at a cost

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The UK government's National Infrastructure Plan has helped focus attention on opportunities for investing in areas such as schools, hospitals and transport, in many cases through public private partnerships (PPP and P3) or private finance initiative (PFI) projects.

This has encouraged a number of UK pension funds to jointly launch a pension infrastructure platform, which is expected to get underway by investing £2 billion in infrastructure projects over the next 12 months.

Individual investors have been able to gain diversified exposure to the infrastructure sector since March 2006, when HSBC Infrastructure was launched as a Guernsey-based, but London-quoted, offshore investment company. Now known as HICL Infrastructure (HICL), it has proved popular with investors and has been able to greatly expand its issued capital.

HICL has been joined by five more offshore investment companies that focus on infrastructure projects in the UK and other developed economies. There are several good reasons for considering an investment among this growing band - and several other reasons for treading cautiously.

Attractive yields

On the positive side, infrastructure companies offer attractive yields that are at least partly inflation linked, while the valuation of their asset base has a low correlation with equities and has historically been much less volatile. The funds should serve as good stabilisers in a diversified portfolio.

Reasons for caution include the premium ratings quoted on funds - they were on wide discounts to net asset value three years ago. The move from discount to premium has enhanced share price returns to investors but is unlikely to go further and could be undermined by the issuing of new shares.

It is argued that issuing more shares helps spread running costs over a wider base and improves liquidity in the shares, but it can dilute portfolio exposure to its most rewarding projects. It may also encourage managers to venture into riskier or less rewarding areas - especially now that the government is under pressure to keep the terms of any infrastructure contracts tighter than in the past.

As long as investors can get an allocation in a secondary issue in an infrastructure investment company, they will generally be better off doing so and buying at close to net asset value, rather than buying existing shares in the market at a premium.

Another caveat is that because all infrastructure companies are based offshore, their yield is quoted gross. It is therefore liable to basic as well as higher-rate tax, unless the shares are held through a self-invested personal pension or ISA.

Yet another concern is that the relatively steady returns from infrastructure may look less attractive as and when investors believe a sustainable bull market in equities is underway.

The risks are demonstrated by their average net asset value (NAV) total returns, which are well ahead of the FTSE All-Share index over one and five years but well behind over three years. In addition, the high yields will look less appealing when gilt yields rise.

While some commentators believe the 30-year bull market in bonds is coming to an end, other disagree. But if inflation gets a grip and interest rates rise, the NAV per share of the infrastructure vehicles will be adversely affected, as it is calculated using a discounted cash flow model that only works in favour of those vehicles when interest rates are falling.

Which infrastructure companies?

Further care is needed when deciding which infrastructure companies to support, as they are not a homogeneous group. Investors need to look beyond their yields, discounts and plans for new issuance and consider factors such as their organic growth potential and their currency exposure.

3i Infrastructure (3IN) arguably has an above-average risk profile, as it invests in more regulated and demand-based assets than its peers, and these are more vulnerable than availability-based projects to the economic cycle. In addition, it has a significant exposure to Indian infrastructure.

It targets an annual total return of 12%, whereas most other funds target between 7% and 9%. It has so far failed to deliver, partly because it has had too much of its portfolio in cash. The fund was spun out of 3i Group (III) in May 2007, but 3i retains a 34% stake, which could be up for grabs if it is taken over or when its new chief executive takes charge.

International Public Partnerships (INPP) is the second-oldest fund in the sector. It currently trades on one of the highest premiums, although this could be undermined by a further round of fundraising.

IPP is popular because its portfolio is increasingly diversified geographically, with UK exposure down to around 55%, despite a big investment last year in Building Schools for the Future. Also it claims that 70% of its revenue is inflation linked in some way. Around a quarter of its portfolio is under construction, of which two-thirds is due for completion within 18 months.

As completed projects are more highly valued and begin to generate income, this should enhance its NAV per share and lend support to the steady 3% annual increase in its dividend payments. IPP's base fee is unexceptional, but it has the potentially highest performance fee at 20% of share price total return.

GCP Infrastructure (GCP) is different in that it invests in senior and junior tranches of debt, often secured on cash flows generated by UK PFI companies.

It offers the highest yield in the sector, but it is very small and arguably higher risk, as it is UK only and reliant on PFI cashflows over which it has little influence. Also it earns some of its income from insuring senior lenders against the first loss on portfolios of senior PFI loans.

It is too early to form an opinion on Bilfinger Berger Global Infrastructure (BBGI), which raised £212 million at its December 2011 launch, so the other two options are HICL (see above) and John Laing Infrastructure (JLIF), which was launched in November 2010.

The latter has a broadly similar portfolio to IPP but has only 30% or so overseas, mainly in Canada. Another difference is its strong focus on projects that are already operational. As a result, it has a lower risk profile but less growth potential.

Spotlight on HICL Infrastructure

HICL has achieved a 46% NAV total return over the past five years, in line with 3i Infrastructure and well ahead of IPP. It has raised its dividend every year and expects to pay out 7p in the year to March 2013.

The premium on its shares has fallen from a peak of 7.7%, partly because HICL raised £250 million through a heavily oversubscribed C share issue in March. More than half the proceeds of the C share issue have been used to repay £139 million of debt, freeing up HICL's £150 million borrowing facility for future investments.

A further £39 million has been used to acquire a stake in the Connect PFI project, which has a concession running until 2019 to upgrade London Underground's radio and telecommunications network. With other new investments in an advanced stage of negotiation, there should be minimal cash drag when the C shares are converted into ordinary shares at the end of April.

The company is managed by InfraRed Capital Partners, which bought out HSBC's infrastructure and real estate business. The team of 32 specialists manages three other infrastructure funds with combined assets of around £900 million.

HICL's portfolio holds stakes in more than 70 projects in government accommodation, education, health, transport, utilities and law and order. Although it also has stakes in a high-speed rail project for the Dutch state and a highway project in Canada, its overseas exposure is relatively low, but the manager is exploring projects in Australia, Canada and Europe.

The InfraRed team has expressed an interest in investing up to a third of HICL's assets in projects that are still in the construction phase or in demand-based concessions. These would add to the portfolio's growth potential but are higher risk than its current focus on operational PPP, PFI and P3 concessions.

The management fee is 1 to 1.5% of gross assets, and there is no performance fee.

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